New regulations on money flows

For a couple of weeks now there have been rumors and reports about new foreign exchange regulations being put into place, partly to limit hot money inflows and partly, once these begin to reverse, to make it more difficult for money to leave. Yesterday SAFE announced a new set of measures. Today’s South China Morning Post says the followingOpen in a new window about the announcement:

ChinaOpen in a new window has issued new controls on transfers of foreign currencies, moving to contain growth in its foreign exchange reserves and curb speculative inflows blamed on fuelling inflation. The new rules, issued late Wednesday with immediate effect, call for penalties of up to 30 per cent of the capital involved in any unauthorised inward or outward foreign currency transfers.

“As China’s economy becomes more internationalized and the movement of international capital flows accelerates, there is a need to improve the system and oversight of multinational capital movements,” the State Administration of Foreign Exchange, or SAFE, said in a statement posted on its website.

The new regulations appear broader in scope than new limits announced by SAFE last month that called for authorities to check invoices to ensure they are not being inflated as an excuse to bring unauthorised money into the country. The new rules order government departments to simplify regulations on foreign direct investment and authorises them to crack down on illegal transactions.

Last Friday the State Council said it was revising the rules concerning capital inflows and outflows, and this was generally interpreted as revising the regulations so as to allow the authorities to impose emergency restrictions on a sudden outpouring of money leaving the country. It is clearly important for SAFE to have some handle on inflows and outflows, but I am worried that most policy-makers continue to believe that rapid outflows leading to a 1997-style crisis is the only, or main, risk Cgina faces in relation to the current hot money inflow. In fact in my opinion the main risk is that these inflows have created unsustainable and vulnerable structures within the domestic banking system, in which case the risk of massive outflows is only part of the problem.

The real problem is excess lending leading to misallocated capital, overinvestment, and what Hyman Minsky termed “Ponzi” debt structures, which are clearly already happening, if the evidence of SMEs borrowing at rates of 80% or more suggests anything. The problem is that under these conditons we could easily see a sudden rise in inventories, non-performing loans, capital hoarding, and faulty debt structures among corporations – mainly small and medium enterprises, I would guess. Unfortunately, in my opinion, the only adjustments that will prevent the system from getting worse – specifically a revaluation of the RMB to the point where inflows subside or even slightly reverse – have been put off for so long that it is becoming increasingly hard to see how the authorities will manage an adjustment without triggering problems in the banking sector.

At any rate I know that it is getting increasingly difficult to bring in money for my business here in Beijing. I have a small, independent CD label specializing in developing the Beijing new and experimental music scenes. It is officially registered as a cultural institution (all media companies require that or a similar registration), and we regularly bring in money to pay for operations and production costs, but we have to work harder than ever to bring money in. Unfortunately the capital regulations do not easily distinguish between investors bringing in money to fund real activities in China and investors bringing in money to bet on RMB appreciation. I recognize the desperate need of the PBoC to regain some semblance of control over the money supply, but there are economic costs to doing so, especially onerous for small companies like mine.

Meanwhile both HSBC and RBS, according to BloombergOpen in a new window, have issued reports arguing that RMB forward contracts (NDFs) are priced low enough to offer “clear value”. The recent slowdown in RMB appreciation has convinced many investors to lower their 6-month and 1-year expectations for RMB appreciation, but – and I agree with HSBC and RBS if this is their argument – the reduced pace of appreciation is not sustainable and soon enough, probably before the end of the year, the debate about what to do with the RMB will re-ignite. This will lead to faster appreciation one way or the other.

But for now policy-makers clearly think enough is enough on the appreciation front. Tuesday’s People’s Daily had a very revealing interview Open in a new windowwith Liu He, vice-minister of the Office of the Central Leading Group of Financial and Economic Affairs, which was carried in a lot of other local papers. Mr. Liu clearly seems to believe (or is repeating the government’s position) that China needs to loosen up further on the monetary and credit front.

He says, in response to a question about Hu Jintao’s recent statement about the need to “keep policy stable” that “There is no need to further tighten the marco-control measures. Given the economic environment, the current measures are already appropriate.” In Beijing, it seems to me, the phrase “current measures are already appropriate” is usually code for policy recommendations to relax credit limits and slow RMB appreciation. In case the message was ambiguous, he added “At the moment, we should not rush more tightening measures.”

He also repeated the by-now well-worn phrase: “We shouldn’t sacrifice development to curb inflation.” This is certainly not something anyone would argue against, of course, further and balanced economic development is the key issue for China, but the implicit dichotomy is a false one. The fight against inflation is necessary precisely to ensure continued economic development. It is not an alternative to development.

The most worrying part of the interview was, in my opinion, the following:

Q: Do you think it’s possible to curb excessive inflation by the end of the year?

A: First of all, we should identify the main reason of the inflation. It’s largely due to the depreciation of the US dollar, which triggers price rises of primary goods. For us, the key to deal with inflation is to stabilize our policy, ensure supply, subsidize the poor and adjust prices.

We should also tame the public’s inflation expectations. We should not be afraid of price rises as the adjustment of some underpriced products is unavoidable. But it’s possible for inflation to moderate in the second half as oil price is falling and domestic agricultural supply is recovering. Inflation may well ease by the end of the year.

Given that Chinese inflation has occurred mostly in domestic food prices, little of which is imported, and that many commodity prices, including oil, are price controlled, so that there is little to no pass-through in local costs, it is something of a shock to me that anyone believes that Chinese inflation is caused by a weakening dollar (and even more of a shock that this claim is used to buttress the argument against further appreciation of the RMB).

It is also worrying to me that in the policy response to fighting inflation, taming inflationary expectations is considered a major concern, whereas nothing is said about the role of capital inflows in expanding the domestic money base. I remember in my teenage years in the 1970s there was a belief in the US that then-rising inflation was largely an oil price and expectation problem, and so various administrations jawboned, imposed price controls, wore “Whip Inflation Now” buttons, and did everything else except adjust monetary policy to kill off inflation. It didn’t work. I am not going to pretend that in those years I was more interested in Nixon’s monetary policy than in the rumored upcoming Spanish tour by the Rolling Stones (I was living in Spain then – and unfortunately a sudden burst of ETA terrorism killed plans for the Rolling Stones tour), but I do remember how ineffective those measures turned out to be. I guess I don’t really believe in “inflationary expectations” as a major cause of inflation.

At the end of the interview, Mr. Liu did point out to an important issue that needs to be addressed: “In the second half, we need to push forward reforms in the financial sector. Presently, SMEs are usually the first victims of credit tightening measures. This reflects the rigidity of China’s financial system. Moreover, we need to push forward reforms of the pricing mechanism for energy and resources products.” I think he is certainly right to be concerned about the unequal access to capital for SMEs, although I worry that he is pointing that out mainly to support an argument for credit loosening.

It has been an eventful week in the run-up to the Olympics. Beijing is spruced up, traffic has improved dramatically, the weather is not too bad, most people are in a festive mood (although not artists and musicians – small clubs and CD shops specializing in Beijing art and music are being closed, presumably because the authorities believe foreign visitors will be more impressed with clean, well-scrubbed middle-brow entertainment than with the messy and chaotic cultural vitality Beijing typically exhibits). Even the stock market has been tame and well-mannered, if a little grumpy. It market was slightly up today (0.3%), following a relatively good day yesterday (up 1.1%), although overall for the week to date it is down 2.6%